Author: Andreas Nagstrup, Credit Analyst, Vanguard
The key challenge with indexing a global corporate credit fund is that the benchmark may consist of several thousand securities. Given the over-the-counter (OTC) nature of the credit market and the bid-offer spreads, the cost drag of fully replicating such a large universe would make it near impossible to match the benchmark performance but that is not quite the end of the story.
If you can’t replicate the index, you can sample it. The aim here is to pick securities that in aggregate replicate the characteristics of the benchmark with respect to duration, credit quality, capital structure (senior or subordinated securities), beta, sector, country and currency. In this way, an index of 11,000 bonds can be reduced to a portfolio of 2000—3000 bonds.
The new issue market is a particular challenge for index funds. Issuers often offer concessions to entice investors to buy a new bond, and there are no transaction costs. The decision is whether to buy the bond at the time of issue, taking advantage any concessions and lower costs, or to wait until it goes into the index at the end of the month, by which point it may have either gained or lost value, and you incur transaction costs.
The process for active credit investing is in principle not all that different. An active fund evaluates the same risk factors. However, the aim of an active fund is not to replicate the characteristics of the benchmark but rather to have deliberately different exposures to at least some of these risk factors in the hope of generating a return above the benchmark. Active funds, depending on their objective and its constraints, may be able to take exposure away from the benchmark to further improve performance.
Active funds tend to run more concentrated positions compared to an index fund. Where an index fund may run 2000-3000 positions to replicate the risk factors of its benchmark, an active fund may only run a few hundred positions, securities that the fund manager has conviction will collectively outperform the benchmark.
In the current low yield environment costs are more important than ever for investors. Active funds will tend to be more expensive than index funds. A passive fund may or may not draw on the input of research analysts to pick the right securities to replicate the characteristics of the index, but an active fund will almost certainly use analysts to give the edge necessary to outperform.
As long as costs are proportionate to potential rewards, both active and passive funds can be appropriate choices for a portfolio. Active credit funds can offer additional performance, while a passive fund will usually be a lower cost means of gaining exposure to the market.
In conclusion, index funds do make sense in credit investing. Traditional active funds make sense too. Either can be a great choice for your portfolio. Credit research analysts can play an important role in the management of both active and index credit funds. In the current low yield environment investors need to pay particular attention to costs, whether you invest in an active or an index credit fund, to give yourself the best chance of investment success.
